Compliance: Theory and Practice in the Financial Services Industry

November 2008 Exam Paper

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Instructions to Students

1.    This is an open book examination. There are no restrictions on the notes, books or printed materials which may be taken into the examination room.
2.    There is 30 minutes reading time before the commencement of writing time. During reading time you may make notes on this question paper but no writing in answer books is permitted.
3.    This question paper is divided into 2 sections and is worth 60% of your assessment. You must answer:
  (a)   all 30 questions in Part A (each question correctly answered is worth 1 mark, for a total of 30 marks); and
  (b) the question in Part B (30 marks).
4.    Please answer both Parts in the one answer book. For Part A, write the number of the question and the letter(s) of your selection eg
    1    A, E
    2    C
    3    A, B, D
    And so on
  [Note: these are samples answers only and not the correct answers to questions 1, 2 and 3!]
5.    In Part A, some questions require more than one selection (the question indicates where that is the case). You must provide all of the correct selections, and no incorrect selections, to get the full mark for answering the question correctly.
6.    This question paper must be returned at the end of the examination.


Part A

Multiple Choice:

Answer all 30 questions. [Note: these questions are repeated each year and therefore are not available online. The 2 questions below are indicative of the style of question asked.]

1.    In which of the following situations must a “regulated person” give a product disclosure statement to a retail client? (Hint: more than one answer is required.)
  A.   Any situation where the client has indicated an interest in the product
  B.   A “recommendation” situation
  C.   An “issue” situation
  D.   A “sale” situation
  E.   A “desperate” situation
2.    A client sends an ASX stockbroker a cheque to cover a number of share purchases the client plans to make over the coming days. When must the cheque be deposited into the broker’s client trust account?
  A.   As soon as possible
  B.   On the same business day or the next following business day
  C.   Within 2 business days
  D.   Within 1 month
  E.   It doesn’t have to be deposited because the broker is going to use the cheque to pay for share purchases


Part B

Compulsory Problem Question:

Analyse the following fact situation. What legal or regulatory breaches may have occurred? What other compliance issues are involved? [In answering the question, you may (and should) disregard the recent temporary measures implemented by ASIC and the ASX to regulate short selling).]

You are a compliance officer working for Pitibank Group (“Pitibank”), a global financial services organisation whose businesses include stockbroking, equities research and corporate advisory services. Its broking and equity research activities are carried on through a wholly owned subsidiary, Pitibank Securities Limited (“PSL”). PSL is a participant on the Australian Securities Exchanges (“ASX”).

You receive an enquiry from the market surveillance division of the ASX asking for information about PSL’s recent trading in shares in Fallco Finance Limited (“FFL”), a listed company that specialises in setting up and managing alternative investment funds. You investigate and learn the following information.

A fortnight ago, Pitibank’s corporate advisory group received a defence mandate from FFL. FFL had floated some two years earlier at $20 per share and for a period had performed very well, trading as high as $50 per share. However, its highly geared business model has fallen into significant disfavour with investors in the current financial climate. Its shares are now languishing and trading around $2 per share. The management of FFL fears that with its shares at such a low level, a rival alternative investment firm could well be planning an opportunistic takeover bid for it and it wants to be ready in case that happens.

The defence mandate was assigned to Iva Ferrari, one of Pitibank’s most senior corporate advisors. Iva knew that PSL published research on FFL and so he decided to call Howard Ino, PSL’s analyst who covers the alternative investment sector, to see what he thought about the stock. Howard told Iva that he was about to publish a major research piece on the alternative investment sector, in which he described FFL as a “dog” and said its management has “lost the plot” and that “FFL is likely heading for receivership unless it can find a white knight who can inject significant capital into the business and reduce its gearing”.

Iva blew up and told Howard that FFL is a major client of the firm and that his comments would be hugely embarrassing for Pitibank if they were published. Howard agreed to drop the disparaging remarks about FFL and its management from his research.

Howard’s research is published a week later. In it he describes FFL as significantly undervalued and says that it is an attractive candidate for a takeover bid. He speculates that there are a number of potential suitors who might be interested in making a bid and who would be prepared to pay well above the current market price of $2 per share.

Alec Smart, a PSL proprietary trader, reads Howard’s research on the morning it is published and sees an opportunity to profit from the takeover speculation. He starts aggressively buying up FFL stock. In the course of the morning’s trading, he quickly manages to build up a 5% holding in FFL. His purchases push the price of FFL shares up to $3 per share. Other buyers start to enter the market, thinking that someone may be building a stake to launch a takeover bid.

Ben Darules, the head of PSL stockbroking, notices Alec’s buying activities on the trading screen and becomes concerned. Ben is aware of the FFL defence mandate from a meeting earlier in the week. [Pitibank’s senior executive group have a weekly meeting at which they discuss the firm’s current workloads and possible business opportunities. In the course of that meeting, the head of the corporate advisory group mentioned to all those present, including Ben, that Pitibank had just received a defence mandate from FFL and would be busy working on that for the next few weeks.]

Ben decides he had better have a chat to Alec. He invites Alec to join him for a cigarette on the pavement outside the office. After mentioning that he had noticed Alec’s trading in FFL shares that morning, he says: “Mate, I really need you to stop buying. Something’s up. I can’t tell you what it is or else I would be breaching Chinese Walls. Just take it from me that us buying stock at this point doesn’t look good.”

Upon his return to the office, Alec starts to worry that his trading may get him into trouble. He phones Howard and asks him if he knows what’s going on with FFL. Howard tells him that all he knows is FFL is a client of the firm and that he had been asked to “sugar coat” his research on them. Alec then asks Howard what his real opinion of FFL is. Howard tells Alec: “Mate, let’s just say if it was a horse, it would glued not Viewed.”

Alec’s concern about being in trouble for buying FFL is now supplanted by his concern that he may be about to lose a lot of money on FFL and that this will have a big impact on his bonus later in the year. He decides he should get out of FFL as quickly as he can but he should do something to take advantage of the increased interest in the stock to reduce his losses.

Alec phones the stock lending desk at Pitibank and confirms that it has a line of FFL stock that it can lend. He tells them that he wants to borrow 2% of FFL’s issued shares. He then places a series of sale orders at $3 per share and is successful in selling the entire 2% block he has borrowed. As the trading day draws to a close, Alex continues to place sale orders to rid himself of the other 5% that he purchased on market that morning. His constant selling eventually begins to have an effect on the market price of FFL and the price of FFL shares starts to drop rapidly. Other speculative buyers who purchased the stock earlier in the day begin to panic and they too start to sell. The price of FFL drops to $1.50 with no buyers. Shortly before the close, Alec places a buy order for 2% of FFL’s issued shares to effectively close out his short sale at $1.50 per share. The order executes at the close. Alec has succeeded in selling out of all of the FFL shares he has purchased that morning at roughly break even and has made a handsome profit on the short sale.

Bad Frock and Gown, a competitor of FFL, announces a takeover bid for FFL after the close of trading on the ASX offering to pay $2.25 per share. Its announcement highlights that this is a 50% premium to the closing price of FFL shares on the ASX that day of $1.50 per share.

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